Carbon allowance

What Is Carbon Allowance?

A carbon allowance, often referred to as an emission allowance or permit, is a verifiable authorization to emit a specific amount of greenhouse gases, typically one metric ton of carbon dioxide equivalent ((CO_2e)). These allowances are central to a market-based approach to environmental regulation known as a cap and trade system, falling under the broader category of environmental finance. Governments or regulatory bodies issue a finite number of these allowances, setting an overall limit or "cap" on the total amount of pollution that can be emitted by regulated entities within a specific period. Companies that emit less than their allocated or purchased allowances can sell their surplus to those needing more, creating a market mechanism that incentivizes emission reductions.

History and Origin

The concept of using market mechanisms to control pollution gained traction in the late 20th century, with the Acid Rain Program in the United States, established under the 1990 Clean Air Act Amendments, being a notable early example that successfully reduced sulfur dioxide ((SO_2)) emissions. However, the first large-scale international application of emissions trading for greenhouse gases emerged in the European Union. The European Union Emissions Trading System (EU ETS), launched in 2005, became the world's first major carbon market. Its establishment was a direct response to the need for policy instruments to meet the emissions reduction targets set by the 1997 Kyoto Protocol, although the EU ETS operates independently. The system aimed to facilitate cost-effective reductions in greenhouse gases by creating a tradable carbon allowance asset. Over time, other regions, like California, also adopted robust cap-and-trade programs to achieve ambitious climate goals.⁶, ⁷

Key Takeaways

• A carbon allowance is a permit to emit one metric ton of carbon dioxide equivalent ((CO_2e)) within a regulated system.
• They are a core component of emissions trading or cap-and-trade programs.
• Allowances create an economic incentive for companies to reduce their emissions.
• The total number of available allowances is capped and often decreases over time, driving overall emission reductions.
• Carbon allowances can be traded, establishing a market price for carbon emissions.

Interpreting the Carbon Allowance

A carbon allowance represents a right, not an obligation, to pollute. The value of a carbon allowance is determined by the forces of supply and demand within the specific emissions trading market it operates in. When a company holds a carbon allowance, it signifies that they have the legal right to emit one unit of carbon (or equivalent greenhouse gases) without incurring penalties. The price of an allowance reflects the marginal cost of abatement within the regulated sector; if it's cheaper to reduce emissions than to buy allowances, companies will invest in reduction technologies. Conversely, if abatement is expensive, they will opt to purchase allowances. The declining cap in most systems means allowances become scarcer over time, ideally leading to an increasing carbon pricing signal that encourages long-term decarbonization efforts.

Hypothetical Example

Consider "PowerGen Co.," a hypothetical utility company operating in a region with a cap-and-trade system. The regulatory body sets an annual cap on total emissions and distributes carbon allowances to participating companies. For 2025, PowerGen Co. receives 100,000 carbon allowances, each permitting the emission of one metric ton of (CO_2e).

During the year, PowerGen Co. implements new energy efficiency measures and upgrades its power plants, resulting in actual emissions of 90,000 metric tons of (CO_2e). This means PowerGen Co. has a surplus of 10,000 allowances (100,000 received - 90,000 emitted).

Meanwhile, "SteelWorks Inc.," another company in the same system, finds that its emissions for 2025 total 110,000 metric tons, but it only received 100,000 allowances. SteelWorks Inc. has a deficit of 10,000 allowances. To comply with the regulations, SteelWorks Inc. must acquire an additional 10,000 allowances. It can do so by purchasing them from companies like PowerGen Co. on the market. This transaction benefits PowerGen Co. by monetizing its emission reductions and allows SteelWorks Inc. to meet its compliance market obligations.

Practical Applications

Carbon allowances are primarily used in mandatory emissions trading schemes established by governments or international bodies. These programs, often referred to as "cap and trade," apply to large industrial emitters, power generators, and other significant sources of greenhouse gases. For instance, the California Cap-and-Trade Program, implemented by the California Air Resources Board (CARB), covers approximately 85% of the state's total greenhouse gas emissions, encompassing sectors like electricity, industrial activity, and transportation fuels. Revenue generated from the auctioning of California-owned allowances is often reinvested in projects that further reduce emissions and benefit disadvantaged communities.⁴, ⁵ These allowances create a direct financial mechanism to encourage industries to invest in cleaner technologies and more sustainable practices, thereby reducing their carbon footprint and contributing to broader climate change mitigation efforts. The U.S. Environmental Protection Agency (EPA) notes that such programs provide flexibility for emissions sources, allowing them to choose the most cost-effective path to compliance, whether through internal reductions or allowance purchases.³

Limitations and Criticisms

While carbon allowances and cap-and-trade systems are widely adopted tools for emissions reduction, they face several limitations and criticisms. One significant concern is the potential for initial over-allocation of allowances, which can lead to low carbon prices and diminish the incentive for deep emission cuts, as observed in early phases of some programs. Another challenge is ensuring the integrity of the carbon market itself, including issues like double counting of emissions reductions or concerns about the "additionality" of projects that generate offsets, which can undermine the credibility of the allowances.²

Furthermore, price volatility in carbon markets can complicate long-term investment decisions for companies aiming to transition to lower-carbon operations. Critics also point to the risk of "carbon leakage," where industries might relocate to regions with less stringent environmental regulations to avoid compliance costs, potentially shifting emissions rather than reducing them globally. Addressing these challenges often requires robust monitoring, reporting, and verification systems, along with ongoing policy adjustments to ensure the cap declines sufficiently to achieve ambitious climate change targets. The Brookings Institution highlights that effectively addressing issues like additionality, double counting, and price volatility is essential for carbon markets to function effectively in driving meaningful climate action.¹

Carbon Allowance vs. Carbon Credit

While both a carbon allowance and a carbon credit relate to carbon emissions, they serve distinct functions within the broader carbon market. A carbon allowance is a permit issued by a regulatory body in a mandatory cap-and-trade system. It grants the holder the right to emit one metric ton of (CO_2e) and is part of a finite, decreasing supply set by a governing authority. Companies under a cap-and-trade scheme are required to surrender enough allowances to cover their actual emissions.

In contrast, a carbon credit (or carbon offset) is typically generated from a project that prevents, reduces, or removes one metric ton of (CO_2e) from the atmosphere. These projects often occur outside of regulated sectors, such as renewable energy installations, reforestation initiatives, or methane capture projects. Carbon credits are primarily traded in voluntary carbon markets, where companies or individuals purchase them to offset their own emissions, often as part of corporate social responsibility or sustainability goals. While some cap-and-trade systems allow the use of a limited number of approved carbon credits for compliance, their primary distinction lies in their origin (regulatory allocation vs. project-based generation) and their typical market (mandatory compliance vs. voluntary offsetting).

FAQs

Who issues carbon allowances?

Carbon allowances are issued by governmental or supra-national regulatory bodies responsible for administering cap and trade programs. Examples include the European Commission for the EU ETS or the California Air Resources Board (CARB) for California's program.

How are carbon allowances distributed?

Carbon allowances can be distributed through various methods, including free allocation to historical emitters (often based on past emissions or production benchmarks) or through auctions where companies bid for the right to emit. Most systems use a combination of both.

Can carbon allowances be bought and sold?

Yes, carbon allowances are designed to be tradable commodities. They can be bought and sold on specialized exchanges or through over-the-counter markets, allowing companies to acquire or divest allowances based on their emission performance and compliance needs. This tradability is a core feature of the market mechanism of cap-and-trade systems.

What happens if a company emits more than its allowances?

If a company's emissions exceed the number of carbon allowances it holds, it faces penalties imposed by the regulatory authority. These penalties are typically financial fines per ton of excess emissions and often require the company to make up the deficit in allowances in subsequent periods. This ensures accountability within the environmental regulation framework.